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Optimal Maturity Structure of Sovereign Debt in Situation of Near Default

Gabriel Desgranges () and Celine Rochon

No 14/168, IMF Working Papers from International Monetary Fund

Abstract: We study the relationship between default and the maturity structure of the debt portfolio of a Sovereign, under uncertainty. The Sovereign faces a trade-off between a future costly default and a high current fiscal effort. This results into a debt crisis in case a large initial issuance of long term debt is followed by a sequence of negative macro shocks. Prior uncertainty about future fundamentals is then a source of default through its effect on long term interest rates and the optimal debt issuance. Intuitively, the Sovereign chooses a portfolio implying a risk of default because this risk generates a correlation between the future value of long term debt and future fundamentals. Long term debt serves as a hedging instrument against the risk on fundamentals. When expected fundamentals are high, the Sovereign issues a large amount of long term debt, the expected default probability increases, and so does the long term interest rate.

Keywords: Rational expectations; Long Term Debt, Maturity Structure, Optimal Default, Sovereign Debt Crisis, Uncertainty, debt portfolio, debt burden, sovereign debt, hedging, financial institutions, International Lending and Debt Problems, (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-opm and nep-rmg
Date: 2014-09-12
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